Aside from providing you with a lower rate, refinancing can allow you to take out additional debt from the equity in your home. You might have extra equity if your home has increased in value or if you've paid down the principal on your mortgage. You do not have to worry about being taxed on the refinance cash back, and you might actually get extra tax deductions as a result.
Cash Back Not Taxable
The cash back that you receive when you do a cash-out refinance on your mortgage is not taxable because it is part of a loan. Loan proceeds do not count as taxable income because they do not increase your net worth. For example, if you take out a $50,000 loan, you have $50,000 more money in your pocket or bank account, but you owe $50,000, so the change in your net worth is zero.
Home Equity Debt
Since the cash back you receive as part of the loan is secured by your home, you can deduct the interest on the cash-back portion as home equity debt. This deduction allows you to deduct the interest on up to $100,000 of debt. If you're married but file separately, each spouse can deduct the debt on $50,000 of debt. If you use the cash back to improve your home, it qualifies for the higher mortgage debt interest deduction, but the improvements have to be substantial. For example, replacing a mirror in your bathroom wouldn't count, but completely remodeling a bathroom would.
The debt that you refinanced continues to qualify as mortgage debt, assuming that it was mortgage debt to begin with. This matters, because the deduction limit for mortgage debt is the interest on the first $1 million of debt -- $500,000 if married filing separately -- which is 10 times larger than the home equity debt limit. For example, assume you owe $150,000 on your original mortgage and refinance for $200,000, receiving $50,000 back. The $150,000 that you refinanced continues to count as mortgage debt.
Claiming the Deductions
When you file your income taxes, you can't deduct either your mortgage interest or your home equity debt interest unless you itemize your deductions. To itemize, file Schedule A along with Form 1040 of your tax return. If you receive a Form 1098 that shows the interest you paid on your refinance, report your deduction on line 10. If you didn't, use line 11, and report the name of the person to whom you paid the interest, along with his Social Security number and address.
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